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When Big Law Firms Crumble

Plenty of homeowners have discovered in the past couple of years what it means to be overextended with their banks. Recently some big law firms have learned a similar lesson. Borrowing to fund operating expenses and expansion, they suddenly found nervous bankers at their doorsteps at the earliest sign that their businesses appeared to be in trouble. Three large firms that went out of business in 2008 did so partly because their borrowing put them in a hole.

Take the case of Thacher Proffitt & Wood, a 160-year-old firm in New York. Over much of this decade, Thacher prospered by having platoons of lawyers working on mortgage-backed securities and other "structured-finance" transactions that Wall Street churned out by the thousands. In 2006, Thacher's best year, partners at the firm took home an average of $1.3 million each. Like many firms, Thacher had a mixture of long-term debt to fund expansion and credit lines that could be drawn on to meet payroll and other expenses, particularly early in the year when clients haven't yet paid bills.

When the mortgage market collapsed in late summer of 2007, Thacher's business went into free fall. In 2008 partners began leaving in droves. That alone put Thacher in violation of one of the covenants in its loans. "We tend to find that partner departures are an early warning symbol [of trouble], and we like to have that in our agreements," says Dan DiPietro, head of a Citigroup (C) unit that lends to law firms. (DiPietro emphasizes that he is talking about lending agreements generally, not the specifics of Thacher's situation.) That ratcheted up the bankers' scrutiny of the firm, whose fortunes continued to decline. Revenue in 2008 was off 40% from 2007, while debt stood at about $33 million. When times were flush, that wouldn't have been much, but, as Thacher partner Douglas J. McClintock put it, "When the revenues go down so much, all of a sudden the debt looks a lot bigger."

Bankers' Ultimatum

On Dec. 12, McClintock and other members of Thacher's planning committee sat in a conference room on the 29th floor of the firm's Lower Manhattan offices. A delegation from another law firm, Sonnenschein Nath & Rosenthal, had come by to explore a merger or some other business combination. After an hour or so of discussion, the Thacher lawyers excused themselves and walked around the corner into a different conference room. There representatives of the firm's lenders—Citigroup and Wachovia—threatened to declare the firm in default, which would have required immediate payment of all the debt. That would have required Thacher to close up shop immediately. "The people in the restructuring areas of banks can be very difficult," recalls McClintock. Also, he noted, Thacher did lots of work for Citigroup. "You can't play hardball with one of your largest clients," he says. The Thacher lawyers walked out with the briefest of reprieves: They had one week to cut a deal with Sonnenschein.

Sonnenschein entered the negotiations from a position of strength. Besides having a far more diverse practice than Thacher's—making it less vulnerable to the economic crisis—it also had almost no bank debt, according to Elliott I. Portnoy, Sonnenschein's chairman. Within the one-week period, Sonnenschein put together a deal to take 100 of Thacher's 170 remaining lawyers. (See story.) While Sonnenschein did not assume Thacher's liabilities, Citigroup and Wachovia were intimately involved in the discussions, and the deal could not have happened without their approval. After all, they still need to be paid. "We needed to show the banks that our transaction with Thacher was in their best interest," said Peter D. Wolfson, a Sonnenschein bankruptcy specialist, who participated in the discussions. "If the Thacher people just scattered to the winds, that's bad for lenders."

Thacher itself formally dissolved at yearend. Thelan and Heller Ehrman, two other big law firms that collapsed last year, had also run into trouble with their banks, according to The American Lawyer. So far, says DiPietro of Citigroup, the number of law firms running afoul of terms in their loan agreements is "nothing that you wouldn't see in a typical downturn." But as the economy continues to suffer, Citigroup has stepped up scrutiny of its law-firm borrowers.